Translation of Foreign Currency Financial Statements

1
Chapter 7

• Translation of Foreign Currency Financial
  Statements

2
Translation of Foreign Currency Financial
Statements

• Conceptual issues of foreign currency financial
  statements translation.
• Balance sheet vs. transaction exposure.
• Methods of financial statement translation.
• Temporal and current rate methods illustrated.
• U.S. GAAP, IFRSs, and other standards related to
  translation.
• Hedging balance sheet exposure.

3
Translating Foreign Currency Financial Statements
-- Conceptual Issues

• Foreign country operations usually prepare
  financial statements using local currency as the
  monetary unit.
• These financial statements must be translated
  into home country currency.
• These operations also typically use local GAAP.
• Financial statements must be translated into home
  country GAAP.

Learning Objective 1
4
Translating Foreign Currency Financial Statements
-- Conceptual Issues

• Primary conceptual issues
• Each financial statement item must be translated
  using some, hopefully relevant, exchange rate.
• What rate should be used?
• the current exchange rate?
• The average exchange rate?
• the historical exchange rate?
• Given that any adjustment is, at the point of
  translation, unrealized, how should the
  resulting adjustment be recognized?
• in current income?
• in an equity account on the balance sheet?

Learning Objective 1
5
Balance Sheet Exposure

• Assets and liabilities translated at the current
  exchange rate are exposed to risk of a
  translation adjustment.
• When foreign currency appreciates, a net asset
  exposure results in a positive translation
  adjustment.
• When foreign currency appreciates, a net
  liability exposure results in a negative
  translation adjustment.
• Assets and liabilities translated at the
  historical exchange rate are not exposed to a
  translation adjustment.

Learning Objective 2
6
A simple example

• Lets say XYZ has a 1000 euro current note
  receivable on its books. The euro/ direct rate
  is 1 on 1/1. On 12/31, it is 1.20.
• Should we record
• No change?
• An increase in value of 200?
• An increase in value of 100?
• And if we do report a change, where should the
  offsetting gain be reported?

7
Another simple example

• Lets say XYZ has land on its books that is held
  by a subsidiary located in the EU. The land was
  purchased on 1/1 for 1,000,000 euros when the
  euro/ direct rate was 1. On 12/31, it is
  .9091.
• Should we record
• No change?
• An decrease in value of 90,901?
• An decrease in value of 45,450?
• And if we do report a change, where should the
  offsetting gain be reported?

8
What if

• Inflation differences caused the decline in the
  value of the euro?
• If the inflation differential was 10, then
• Before, 1,000,000E1,000,000
• Now, 1,000,000E1,100,000
• Thus the direct exchange rate would be .9091
  (1,000,000/1,100,000).
• Thus the TRUE value of the land, in euros, is now
  1,100,000E. The valuation should be 1100000.9091
  1,000,000, i.e., no change.

9
The difference between these two examples

• The receivable is a monetary asset.
• The land is a non-monetary asset.

10

• If inflation drives foreign exchange rate
  movements, and monetary/non-monetary assets are
  affected differently, how should FC effects be
  accounted for?
• Suppose, in the first case, the land is reported
  at current cost instead of historical cost?

11
Methods devised to sort all this out

• Current/noncurrent
• Monetary/non-monetary
• Temporal
• Current rate

12
Translation Methods

• Current/Noncurrent Method
• Current assets and liabilities are translated at
  the current exchange rate.
• Noncurrent assets and liabilities and
  stockholders equity accounts are translated at
  historical exchange rates.
• There is no theoretical basis for this method.
• Method is seldom used in any countries and is
  not allowed by U.S. GAAP or IFRSs.

Learning Objective 3
13
In our example

• The receivable would be classified as current and
  translated using the current rate.
• The land would be classified as noncurrent and
  translated at the historical rate.

14
Curent/Noncurrent

• Advantages?
• Simplistic. Requires no more characterization of
  assets/liabilities than is already provided by
  the financial statements
• Disadvantages?
• Can mismatch exchange rate with valuation basis.
  Example inventories, noncurrent marketable
  equity securities

15
Translation Methods

• Monetary/Nonmonetary Method
• Monetary assets and liabilities are translated at
  the current exchange rate.
• Nonmonetary assets and liabilities and
  stockholders equity accounts are translated at
  historical exchange rates.
• The translation adjustment measures the net
  foreign exchange gain or loss on current assets
  and liabilities as if these items were carried on
  the parents books.

Learning Objective 3
16
In our example

• The receivable would be translated using the
  current rate.
• The land would be translated at the historical
  rate, even is it were considered impaired and
  thus reported at fair value.

17
Monetary/Non-monetary

• Advantages
• Easy to understand. Makes intuitive sense.
• Usually not difficult to classify assets and
  liabilities.
• Disadvantages
• Valuation basis in accounting doesnt always line
  up right with classification, producing
  meaningless values. Examples impaired assets,
  fixed assets revalued upwards, long term
  liabilities such as bonds.

18
Translation Methods

• Temporal Method
• Objective is to translate financial statements as
  if the subsidiary had been using the parents
  currency.
• Items carried on subsidiarys books at historical
  cost, including all stockholders equity items
  are translated at historical exchange rates.
• Items carried on subsidiarys books at current
  value are translated at current exchange rates.
• Income statement items are translated at the
  exchange rate in effect at the time of the
  transaction.

Learning Objective 3
19
In our example

• The receivable translated using the current rate.
  
• If reported at historical cost, the land would be
  translated at the historical rate.
• If reported at fair value, the land would be
  translated at the current rate.

20
Temporal Method

• Advantages
• Lines up with valuation basis used in accounting.
  Thus the numbers have most meaning.
• Disadvantages
• Lots of volatility in financial statements
• Possibility of disappearing assets in
  inflationary economies.

21
Translation Methods

• Current Rate Method
• Objective is to reflect that the parents entire
  investment in a foreign subsidiary is expose to
  exchange risk.
• All assets and liabilities are translated at the
  current exchange rate.
• Stockholders equity accounts are translated at
  historical exchange rates.
• Income statement items are translated at the
  exchange rate in effect at the time of the
  transaction.

Learning Objective 3
22
Current Rate Method

• Advantages
• Simple to do
• Ratios are not distorted
• Disadvantages
• Can produce disparate results that are not
  consistent with the economics that are really
  going on.
• What does the FC adjustment?

23
In our example

• The receivable would be translated using the
  current rate.
• The land would be translated at the current rate.

24
Temporal and Current Rate Methods

• Translation methods illustrated
• U.S. Inc. owns Juarez, SA, a subsidiary in Mexico
  which was established January 1, 2005.
• Juarezs balance sheet items as of 12/31/05, in
  pesos.
• Cash 1,000 Accounts payable 2,000
• Accounts rec. 2,000 Long-term debt 6,000
• Inventory 2,500 Capital stock 3,000
• Fixed assets 8,000 Retained earnings 1,500
• Accum. depr. 1,000

Learning Objective 4
25
Temporal and Current Rate Methods

• Translation methods illustrated
• Juarezs income statement items for 2005, in
  pesos.
• Sales 20,000 Depr. exp 1,000
• COGS 14,000 Interest exp. 500
• S,G,A exp. 2,500 Income tax exp. 500

Learning Objective 4
26
Temporal and Current Rate Methods

• Translation methods illustrated
• There was no beginning inventory.
• Inventory, which is carried at cost, was acquired
  evenly during the last quarter of 2005.
• Purchases were made evenly throughout year.
• Fixed assets were acquired on January 1, 2005.
• Capital stock was sold on January 1, 2005.

Learning Objective 4
27
Temporal and Current Rate Methods

• Translation methods illustrated
• Relevant exchange rates (U.S. dollar per Mexican
  peso)
• January 1, 2005 0.10
• Average for 2005 0.095
• Average for 4th quarter 2005 0.09
• December 31, 2005 0.08

Learning Objective 4
28
Temporal and Current Rate Methods

• Current Rate Method Income Statement
• Income Statement 2005
• Sales 1,900
• COGS 1,330
• Gross profit 570
• S,G,A 238
• Depreciation expense 95
• Interest expense 48
• Income tax expense 47
• Net income 142

Learning Objective 4
29
Temporal and Current Rate Methods

• Current Rate Method Balance Sheet
• Balance Sheet December 31, 2005
• Cash 80 Accounts payable 160
• Accounts Rec. 160 Long-term debt 480
• Inventory 200 Capital stock
  300
• Fixed Assets, net 545 Retained earnings
  142
• Total assets 985 Cumulative
• translation adj. (97) Total liab.
  S.E. 985

Learning Objective 4
30
Temporal and Current Rate Methods

• Temporal Method Balance Sheet
• Balance Sheet December 31, 2005
• Cash 80 Accounts payable 160
• Accounts Rec. 160 Long-term debt 480
• Inventory 225 Capital stock 300
• Fixed Assets, net 700 Retained earnings
  225
• Total assets 1,165 Total liab. S.E. 1,165

Learning Objective 4
31
Temporal and Current Rate Methods

• Temporal Method Balance Sheet
• Income Statement 2005
• Sales 1,900
• COGS 1,343
• Gross profit 557
• S,G,A 238
• Depreciation expense 100
• Interest expense 48
• Income tax expense 47
• Remeasurement gain 101
• Net income 225

Learning Objective 4
32
Temporal and Current Rate Methods

• Translation methods illustrated Summary
• Current Rate Method
• All assets and liabilities translated at current
  rate.
• This results in net asset exposure.
• Net asset exposure and devaluing foreign currency
  results in translation loss.
• Translation adjustment included in equity.

Learning Objective 4
33
Temporal and Current Rate Methods

• Translation methods illustrated Summary
• Temporal Method
• Primarily monetary assets and liabilities
  translated at current rate.
• This results in net liability asset exposure.
• Net liability exposure and devaluing foreign
  currency results in translation gain.
• Translation gain included in current income.

Learning Objective 4
34
Other Issues

• What is the appropriate current rate?
• Translation gains/losses? Deferred or booked?
  Shown in income or just equity?

35
Translation Accounting Around the World

• USA
• IFRS
• Diversity seen in other nations

36
History of Translation Accounting in USA

• Pre-1965 Current/Noncurrent method applied.
  Losses recognized into income. Gains were
  deferred.
• 1965-1975 Single Rate method was also allowed.
• 1975-1981 FAS 8, which required temporal method
  to be used. All gains and losses taken into income

37
History of Translation Accounting in USA

• 1981-today SFAS 52, which has the following
  features
• Functional currency determines accounting.
• If functional currency is the local currency- use
  single current rate. Gains and losses routed
  directly to stockholders equity.
• If functional currency is US Dollar, use the
  temporal method and fully recognize gains/losses
  into earnings.
• If functional currency is different from local
  currency or US Dollar, do both.

38
U.S. GAAP and IFRS Requirements

• U.S. GAAP under SFAS 52
• Requires identification of functional currency.
• Functional currency is the primary currency of
  the foreign subsidiarys operating environment.
• The standard includes a list of indicators as
  guidance for the foreign currency decision.

Learning Objective 5
39
Advantages of SFAS 52

• Allows consideration of context.
• In most cases, keeps impact of FC exchange rate
  movements out of earnings.
• Much more accepted by reporting community than
  FAS 8 was.

40
Disadvantages of SFAS 52

• From an investors viewpoint, is there any
  economic difference, in substance, between
  circumstances that distinguish the two methods.
  If not, why have two different kinds of
  accounting?
• Inconsistent with the notion of consolidation.
• Numbers produced by SFAS 52 often lose meaning.
• Added risk of earnings management?

41
U.S. GAAP and IFRS Requirements

• IFRS
• IAS 21, The Effects of Changes in Foreign
  Exchange Rates is the relevant accounting
  standard.
• Uses the functional currency approach developed
  by the FASB.
• The standard includes a list, similar to the FASB
  list, of indicators as guidance for the foreign
  currency decision.
• The standards requirements pertaining to
  hyperinflationary economies are substantially
  different from SFAS 52.

Learning Objective 5
42
U.S. GAAP and IFRS Requirements

• Highly Inflationary Economies U.S. GAAP
• SFAS 52 provides guidance on highly inflationary
  economies.
• SFAS 52 defines such economies as those with 100
  inflation over a period of three years.
• SFAS 52 requires the use of the temporal method
  in these cases of significant inflation.

Learning Objective 5
43
U.S. GAAP and IFRS Requirements

• Hyperinflationary Economies -- IFRSs
• IAS 21 and 29 use the term hyperinflationary
  economies.
• IAS 21 is not as specific in defining
  hyperinflationary economies as SFAS 52.
• IAS 21 requires restatement of the foreign
  financial statements for inflation per IAS 29,
  Financial Reporting in Hyperinflationary
  Economies.
• IAS 21 then requires the use of the current rate
  method of translation on the restated financial
  statements.
• IAS approach is substantially different from SFAS
  52.

Learning Objective 5
44
Hedging Balance Sheet Exposure

• Companies that have foreign subsidiaries with
  highly integrated operations use the temporal
  method.
• The temporal method requires translation gains
  and losses to be recognized in income.
• Losses negatively affect earnings, and both gains
  and losses increase earnings volatility.

Learning Objective 6
45
Hedging Balance Sheet Exposure

• These gains and losses result from the
  combination of balance sheet exposure and
  exchange rate fluctuations.
• Companies can also hedge to offset the effects of
  the translation adjustment to equity under the
  current rate method.
• Companies can hedge against gains and losses by
  using foreign currency forward contracts,
  options, and borrowings.

Learning Objective 6
46
Translation Procedures Internationally

• Canada very similar to U.S., however under the
  temporal method, some translations adjustments
  can be deferred and amortized.
• Mexico standards are silent, but SFAS 52 is
  commonly followed. In cases where it is not,
  practice varies widely.
• Brazil current rate method is used with gains
  and losses included in income.
• Japan significantly different from U.S. GAAP
  and IFRSs, with cumulative translation adjustment
  reported as an asset or liability.
• Korea only the current rate method is used.

Learning Objective 7
47
One final problem

• How do we interpret reported FC gains and losses,
  irrespective of where they show up?
• Example Company has a large subsidiary in the
  EU. The subsidiary has a large net asset
  position. The Euro depreciates more than 40.
  Huge losses are reported.
• The subsidiarys sales and profits skyrocket,
  since they now seem more competitive to customers
  than ever.

48
Thus, and strangely

• In a world of floating rate currency, sometimes
  a weak currency is good, and a strong currency is
  bad!
• This explains why, when markets are tight or
  declining, nations compete with each other in a
  race to devalue their money the most!

49
Summary

• All kinds of problems arise when the value of
  money changes and is uncertain.
• The economic impact of these changes vary as a
  function of the inherent cause of the FC movement
  and the type of holding (asset/liability
  monetary/non-monetary current/noncurrent).
• Accounting limitations (e.g., historical cost)
  mix with this uncertainty, making financial
  reporting difficult at best.
• The current paradigm is SFAS 52. This could
  easily change at any time, as it has several
  times before.